Living in a High Frequency World

Today – although for only a brief 90 seconds of pandemonium – we witnessed the perfect storm of highfrequency news dissemination via social media (twitter), mixed with highfrequency algorithmic trading, amid a backdrop of highfrequency mood swings abetted by recent terrorist acts and a market that neither the experts nor the noobs are properly positioned in.

A little after 1pm Eastern, the Associated Press (AP) twitter account was hacked and published a message announcing that two bombs had just exploded at the White House and President Barack Obama had been injured. As this twitter message was quickly retweeted, commented upon, and reacted against, the stock market as measured by the S&P 500 ($SPY) did this…

Meanwhile, in simultaneous action, the high frequency algo bots who so proudly proclaim their utility to markets in the form of “added liquidity” did this in America’s “deepest most liquid market” the S&P 500 futures contract…

courtesy nanex, via @zerohedge

The red oval shows you where liquidity (bids and offers) used to be, gone in a nanosecond.

Bottom line, friends: Retail traders with timeframes shorter than a week have no reasonable shot in this marketplace if you trade any product or manage any position that requires you to leave open stop orders with your broker to protect your capital. Forget about it. You’re toast. Maybe not today, maybe not tomorrow. But the game is stacked against you, and the house edge always wins.

As these shenanigans continue to happen and the exchanges quietly count their ever-rising trading fees from HFT firms – while our elected and nominated government officials quietly collect campaign donations to keep the status quo (cash cow) – what can the little guy (you and me) do to limit our chances of getting whipsawed by yet another algo gone wild, fraudulent/mis-reported news item, hacked twitter account, or blatant market structure abuse (it will happen)?

Well, I don’t have the complete answer, but my hunch has me leaning exclusively towards options.

With options, a trader or investor can structure a trade that properly expresses his opinion of market direction, yet do so with explicitly defined risk. The simplest strategy is to simply purchase options. You can be long call options in stock XYZ which trades at $75.00. If you size your position properly (meaning, the max risk to your portfolio is well within reasonable limits), then XYZ can flash crash all the way down to $00.01, but it won’t matter to you in the least. You will have only lost what you planned to risk, nothing more. Trade simply didn’t work out… on to the next one. Or, perhaps you’ve deemed that if XYZ trades below $74.00, then your reason for being in the trade is invalidated? Well, what if XYZ was hit with one of those mini-flashes that now seem to happen every day (see Google just yesterday!) and it traded down to $71 only to quickly (before you can bat an eyelid) return right back to its previously trending price around $75? If you were holding stock, your stop-loss would’ve been triggered and you’d be out (at your price in the event of a stop-limit order, or worse – at the very bottom of the fake move in the case of a stop-market order). Meanwhile, the lonely option trader in the same position holding long XYZ calls just sits back on his hands and watches the drama unfold. Unfazed and unharmed, and still in his valid position.

Is this the perfect solution? No. It comes with costs in the form of premium. Consider that your insurance. Can’t afford insurance? In today’s marketplace, an independent retail Trader simply cannot afford not to have insurance.

/end rant

If you don’t consider yourself well-versed in the field of options, please view these trusted sources for all kinds of free options education. The time is now:

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